**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

** **

|   |                                                                                          | **(MarkOne)** |
|--------|-----------------------------------------------------------------------------------------------|---------------|
|   |                                                                                          |
| ý | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|   |                                                                                          |
|   | **For the quarterly period ended September 30, 2003**                                         |
|   |                                                                                          |
|   | **Or**                                                                                        |
|   |                                                                                          |
| o      | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**CommissionFile Number 000-24289**

 

**CLICK2LEARN,INC.**(Exact name ofregistrant as specified in its charter)

 

| **Delaware**                                                    |   | **91-1276003**                       |
|-----------------------------------------------------------------|--------|--------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |   | (I.R.S. Employer Identification No.) |
|                                                            |   |                                 |
| **110-110th Avenue NE, Bellevue, Washington**                   |   | **98004**                            |
| (Address of principal executive offices)                        |   | (Zip Code)                           |
|                                                            |   |                                 |
| **(425) 462-0501**                                              |
| (Registrant’s telephone number, including  area code)      |

 

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. Yes  ý   No  o

 

Indicate by check mark whether the registrant is an accelerated filer(as defined in Rule 12b-2 of the Exchange Act). Yes  o   No  ý

 

The number of shares outstanding of the issuer’s Common Stock, parvalue $0.01, as of October 15, 2003 was 32,626,731 shares.

 

 

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**CLICK2LEARN,INC.**

**FORM10 –Q**

**Forthe Quarter Ended September 30, 2003**

**TABLEOF CONTENTS**

 
| **PART I – FINANCIAL INFORMATION** |
|-----------------------------------------|
|                                    |   |   |
| Item 1.                                 | Financial  Statements |
|                                    |   |   |
|                                    | Unaudited Condensed Consolidated Balance Sheets as of September 30,  2003 and December 31, 2002 |
|                                    |   |   |
|                                    | Unaudited Condensed Consolidated Statements  of Operations for the three and nine months ended September 30, 2003 and 2002 |
|                                    |   |   |
|                                    | Unaudited Condensed Consolidated Statements  of Cash Flows for the nine months ended September 30, 2003 and 2002 |
|                                    |   |   |
|                                    | Notes to  Unaudited Condensed Consolidated Financial Statements |
|                                    |   |   |
| Item 2.                                 | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |
|                                    |   |   |
| Item 3.                                 | Quantitative  and Qualitative Disclosures About Market Risk |
|                                    |   |   |
| Item 4.                                 | Controls  and Procedures |
|                                    |   |   |
| **PART II – OTHER INFORMATION**    |
|                                    |   |   |
| Item 1.                                 | Legal Proceedings |
|                                    |   |   |
| Item 2.                                 | Change in Securities and Use of Proceeds |
|                                    |   |   |
| Item 3.                                 | Defaults upon Senior Securities |
|                                    |   |   |
| Item 4.                                 | Submission of Matters to a Vote of  Securities Holders |
|                                    |   |   |
| Item 5.                                 | Other  Information |
|                                    |   |   |
| Item 6.                                 | Exhibits  and Reports on Form 8-K |
|                                    |   |   |
| **SIGNATURES**                          |

 

2

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**PART I – FINANCIAL INFORMATION**

**Item1****.  Financial Statements**

 

**CLICK2LEARN, INC. AND SUBSIDIARIES**

**UNAUDITED CONDENSED CONSOLIDATEDBALANCE SHEETS**

**(In thousands except share data)**

** **
|                                                                                                                                           |   | **September  30,  2003** |   | **December  31,  2002** |   |
|------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------|--------|-------------------------|--------|
| **Assets**                                                                                                                                     |   |                     |   |                    |   |
|                                                                                                                                           |   |                     |   |                    |   |
| Current assets:                                                                                                                                |   |                     |   |                    |   |
| Cash and cash equivalents                                                                                                                      |   | $                        | 14,909 |                    | $      | 3,586 |   |
| Accounts receivable, net of allowance for  returns and doubtful accounts of $454 in 2003 and $927 in 2002                                      |   | 9,445                    |   | 10,785                  |   |
| Prepaid royalties and licenses                                                                                                                 |   | 43                       |   | 157                     |   |
| Other                                                                                                                                          |   | 1,065                    |   | 1,619                   |   |
| Total current assets                                                                                                                           |   | 25,462                   |   | 16,147                  |   |
| Property and equipment, net                                                                                                                    |   | 939                      |   | 1,214                   |   |
| Goodwill                                                                                                                                       |   | 2,877                    |   | 2,877                   |   |
| Intangible assets, net                                                                                                                         |   | 3,624                    |   | 4,636                   |   |
| Other                                                                                                                                          |   | 573                      |   | 599                     |   |
| Total assets                                                                                                                                   |   | $                        | 33,475 |                    | $      | 25,473 |   |
|                                                                                                                                           |   |                     |   |                    |   |
| **Liabilities and Stockholders’ Equity**                                                                                                  |   |                     |   |                    |   |
|                                                                                                                                           |   |                     |   |                    |   |
| Current liabilities:                                                                                                                           |   |                     |   |                    |   |
| Accounts payable                                                                                                                               |   | $                        | 1,479  |                    | $      | 2,934 |   |
| Accrued compensation and benefits                                                                                                              |   | 2,560                    |   | 2,294                   |   |
| Deferred revenue                                                                                                                               |   | 3,590                    |   | 4,435                   |   |
| Short term debt                                                                                                                                |   | 3,534                    |   | 2,400                   |   |
| Other                                                                                                                                          |   | 772                      |   | 1,184                   |   |
| Total current liabilities                                                                                                                      |   | 11,935                   |   | 13,247                  |   |
| Other noncurrent liabilities                                                                                                                   |   | —                   |   | —                  |   |
| Total liabilities                                                                                                                              |   | 11,935                   |   | 13,247                  |   |
|                                                                                                                                           |   |                     |   |                    |   |
| Stockholders’ equity:                                                                                                                     |   |                     |   |                    |   |
| Preferred stock, $0.01 par value;  authorized 5,000,000 shares; issued and outstanding no shares in 2003 and  2002                             |   | —                   |   | —                  |   |
| Common stock, $0.01 par value; authorized 100,000,000  shares, issued and outstanding 32,623,856 shares in 2003 and 24,600,114  shares in 2002 |   | 326                      |   | 246                     |   |
| Additional paid-in capital                                                                                                                     |   | 254,754                  |   | 242,570                 |   |
| Accumulated deficit                                                                                                                            |   | (233,058                 | )      | (230,008                | )      |
| Accumulated other comprehensive loss                                                                                                           |   | (482                     | )      | (582                    | )      |
| Total stockholders’ equity                                                                                                                |   | 21,540                   |   | 12,226                  |   |
| Total liabilities and stockholders’ equity                                                                                                |   | $                        | 33,475 |                    | $      | 25,473 |   |

 

See accompanyingnotes to unaudited condensed Consolidated Financial Statements

 

3

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**CLICK2LEARN, INC. AND SUBSIDIARIES**

**UNAUDITEDCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

**(In thousands, except per share data)**

 

** **
|                                                           |   | **Three Months Ended  September 30,** |   | **Nine Months Ended  September 30,** |   |
|----------------------------------------------------------------|--------|---------------------------------------|--------|--------------------------------------|--------|
|                                                           |   | **2003**                              |   | **2002**                             |   | **2003** |   | **2002** |   |
|                                                           |   |                                  |   |                                 |   |   |   |   |   |
| Revenue:                                                       |   |                                  |   |                                 |   |   |   |   |   |
| Platforms                                                      |   | $                                     | 6,443  |                                 | $      | 5,295 |   | $ | 19,866 |   | $ | 16,231 |   |
| Tools                                                          |   | 672                                   |   | 907                                  |   | 2,230 |   | 3,402 |   |
| Content services                                               |   | 398                                   |   | 737                                  |   | 1,547 |   | 2,218 |   |
| Total revenue                                                  |   | 7,513                                 |   | 6,939                                |   | 23,643 |   | 21,851 |   |
|                                                           |   |                                  |   |                                 |   |   |   |   |   |
| Cost of revenue:                                               |   |                                  |   |                                 |   |   |   |   |   |
| Platforms                                                      |   | 1,812                                 |   | 1,306                                |   | 5,332 |   | 4,593 |   |
| Tools                                                          |   | 140                                   |   | 268                                  |   | 398 |   | 950 |   |
| Content services                                               |   | 383                                   |   | 577                                  |   | 1,401 |   | 1,884 |   |
| Total cost of revenue                                          |   | 2,335                                 |   | 2,151                                |   | 7,131 |   | 7,427 |   |
| Gross margin                                                   |   | 5,178                                 |   | 4,788                                |   | 16,512 |   | 14,424 |   |
|                                                           |   |                                  |   |                                 |   |   |   |   |   |
| Operating expenses:                                            |   |                                  |   |                                 |   |   |   |   |   |
| Research and development                                       |   | 1,731                                 |   | 1,924                                |   | 4,658 |   | 6,376 |   |
| Sales and marketing                                            |   | 3,308                                 |   | 3,690                                |   | 10,485 |   | 12,952 |   |
| General and administrative                                     |   | 1,467                                 |   | 1,182                                |   | 4,217 |   | 4,221 |   |
| Employee severance                                             |   | —                                |   | 485                                  |   | — |   | 485 |   |
| Total operating expenses                                       |   | 6,506                                 |   | 7,281                                |   | 19,360 |   | 24,034 |   |
| Operating loss from continuing operations                      |   | (1,328                                | )      | (2,493                               | )      | (2,848 | ) | (9,610 | ) |
|                                                           |   |                                  |   |                                 |   |   |   |   |   |
| Other income (expense)                                         |   | (8                                    | )      | 15                                   |   | (101 | ) | 28 |   |
| Equity in losses of affiliate                                  |   | (25                                   | )      | (25                                  | )      | (75 | ) | (175 | ) |
| Loss from continuing operations before  income taxes           |   | (1,361                                | )      | (2,503                               | )      | (3,024 | ) | (9,757 | ) |
|                                                           |   |                                  |   |                                 |   |   |   |   |   |
| Income tax                                                     |   | (8                                    | )      | —                               |   | (26 | ) | — |   |
| Loss from continuing operations                                |   | (1,369                                | )      | (2,503                               | )      | (3,050 | ) | (9,757 | ) |
|                                                           |   |                                  |   |                                 |   |   |   |   |   |
| Loss from discontinued operations                              |   | —                                |   | (4,949                               | )      | — |   | (7,600 | ) |
| Net loss                                                       |   | $                                     | (1,369 | )                                    | $      | (7,452 | ) | $ | (3,050 | ) | $ | (17,357 | ) |
|                                                           |   |                                  |   |                                 |   |   |   |   |   |
| Amounts per share, basic and diluted:                          |   |                                  |   |                                 |   |   |   |   |   |
| Loss from continuing operations                                |   | $                                     | (0.04  | )                                    | $      | (0.10 | ) | $ | (0.11 | ) | $ | (0.40 | ) |
| Loss from discontinued operations                              |   | —                                |   | (0.20                                | )      | — |   | (0.31 | ) |
| Net loss                                                       |   | $                                     | (0.04  | )                                    | $      | (0.30 | ) | $ | (0.11 | ) | $ | (0.71 | ) |
|                                                           |   |                                  |   |                                 |   |   |   |   |   |
| Weighted average common shares outstanding,  basic and diluted |   | 32,500                                |   | 24,498                               |   | 27,721 |   | 24,321 |   |

 

Seeaccompanying notes to unaudited condensed Consolidated Financial Statements

 

4

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**CLICK2LEARN, INC. AND SUBSIDIARIES**

**UNAUDITEDCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(In thousands)**

** **
|                                                                                        |   | **For the  Nine Months Ended  September 30,** |   |
|---------------------------------------------------------------------------------------------|--------|-----------------------------------------------|--------|
|                                                                                        |   | **2003**                                      |   | **2002** |   |
| Cash flows from operating activities:                                                       |   |                                          |   |   |   |
| Continuing operations:                                                                      |   |                                          |   |   |   |
| Net loss                                                                                    |   | $                                             | (3,050 | ) | $ | (9,757 | ) |
| Adjustments to reconcile net loss to net  cash provided by continuing operating activities: |   |                                          |   |   |   |
| Depreciation and amortization                                                               |   | 1,887                                         |   | 1,786 |   |
| Write-off property and equipment                                                            |   | —                                        |   | 270 |   |
| Provision for returns and doubtful accounts                                                 |   | (88                                           | )      | 936 |   |
| Amortization of discount on debt                                                            |   | 66                                            |   | — |   |
| Stock compensation expense                                                                  |   | —                                        |   | 5 |   |
| Equity losses of affiliate                                                                  |   | 75                                            |   | 175 |   |
| Net change in certain operating assets and  liabilities                                     |   | 370                                           |   | 4,411 |   |
| Net cash used in continuing operating  activities                                           |   | (740                                          | )      | (2,174 | ) |
| Discontinued operations:                                                                    |   |                                          |   |   |   |
| Loss from discontinued operations                                                           |   | —                                        |   | (7,600 | ) |
| Accounts receivable forfeited                                                               |   | —                                        |   | 4,475 |   |
| Gain on sale of assets                                                                      |   | —                                        |   | (927 | ) |
| Net cash used in discontinued operating  activities                                         |   | —                                        |   | (4,052 | ) |
| Net cash used in operating activities                                                       |   | (740                                          | )      | (6,226 | ) |
| Cash flows from investing activities:                                                       |   |                                          |   |   |   |
| Continuing operations:                                                                      |   |                                          |   |   |   |
| Purchase of property and equipment                                                          |   | (602                                          | )      | (2,950 | ) |
| Other                                                                                       |   | (50                                           | )      | 18 |   |
| Net cash used in continuing investing  activities                                           |   | (652                                          | )      | (2,932 | ) |
| Discontinued operations:                                                                    |   |                                          |   |   |   |
| Proceeds from sale of assets                                                                |   | —                                        |   | 1,000 |   |
| Net cash provided by discontinued  activities                                               |   | —                                        |   | 1,000 |   |
| Net cash used in investing activities                                                       |   | (652                                          | )      | (1,932 | ) |
| Cash flows from financing activities:                                                       |   |                                          |   |   |   |
| Repayments on debt                                                                          |   | (21,271                                       | )      | (388 | ) |
| Proceeds from borrowings                                                                    |   | 21,622                                        |   | 2,400 |   |
| Proceeds from exercise of stock options                                                     |   | 73                                            |   | 95 |   |
| Net proceeds from sale of common stock                                                      |   | 12,191                                        |   | 532 |   |
| Net cash provided by financing activities                                                   |   | 12,615                                        |   | 2,639 |   |
| Effect of foreign exchange rate changes on  cash                                            |   | 100                                           |   | (26 | ) |
| Net increase (decrease) in cash and cash  equivalents                                       |   | 11,323                                        |   | (5,545 | ) |
| Cash and cash equivalents at beginning of  period                                           |   | 3,586                                         |   | 9,553 |   |
| Cash and cash equivalents at end of period                                                  |   | $                                             | 14,909 |   | $ | 4,008 |   |

 

See accompanyingnotes to unaudited condensed Consolidated Financial Statements

 

5

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CLICK2LEARN, INC.

NOTESTO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

 

**NOTE1:  SUMMARY OF SIGNIFICANT ACCOUNTINGPOLICIES**

 

(a) Description of Business

 

Click2learn, Inc.(“Click2learn”) develops, markets, distributes, and supports an integratedsuite of enterprise learning software products.  Click2learn’s markets are worldwide and include a broad range ofindustries.

 

(b) Basis of Presentation

 

The accompanying unaudited condensedconsolidated financial statements of Click2learn, Inc., (“Click2learn”) includethe accounts of Click2learn and its wholly-owned subsidiaries.  All significant intercompany transactionshave been eliminated in consolidation.

 

These statements reflect all normal recurring adjustments, which, inthe opinion of management, are necessary for a fair presentation of thefinancial position and results of operations for the periods presented.  Interim results of operations for the threeand nine months ended September 30, 2003 are not necessarily indicative of theoperating results for the full fiscal year. Factors that may affect such operating results, include, but are notlimited to, those discussed in **“Factors That May Affect Future Results ofOperations.”**  Certaininformation and footnote disclosures normally included in financial statementsprepared in conformity with accounting principles generally accepted in theUnited States of America have been condensed or omitted pursuant to the rulesand regulations of the Securities and Exchange Commission.

 

These condensed consolidated financialstatements should be read in conjunction with the consolidated financialstatements and related notes included in Click2learn’s Annual Report on Form10-K for the year ended December 31, 2002.

 

(c) Other Current Assets

 

The following table sets forth the componentsof other current assets (in thousands):

 
|                       |   | **September  30,  2003** |   | **December  31,  2002** |   |
|----------------------------|--------|--------------------------|--------|-------------------------|--------|
| Prepaid expense            |   | $                        | 455    |                    | $      | 430 |   |
| Prepaid insurance          |   | 351                      |   | 618                     |   |
| Other                      |   | 259                      |   | 571                     |   |
| Total other current assets |   | $                        | 1,065  |                    | $      | 1,619 |   |

 

(d) Revenue Recognition

 

Click2learn recognizes revenue pursuant tothe requirements of Statement of Position No. 97-2, *Software Revenue Recognition* (“SOP 97-2”), as amended byStatement of Position No. 98-9, *SoftwareRevenue Recognition with Respect to Certain Arrangements.* Under SOP97-2, revenue attributable to an element in a customer arrangement isrecognized when persuasive evidence of an arrangement exists and delivery hasoccurred, provided the fee is fixed or determinable, collectibility is probableand the arrangement does not require significant customization of the software.

 

For all sales, Click2learn uses either abinding purchase order or signed agreement, depending on the nature of thetransaction, as evidence of an arrangement. Sales through its significantresellers are evidenced by a master agreement governing the relationship.

 

6

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For software license fees in single elementarrangements and multiple element arrangements that do not includecustomization or consulting services, delivery typically is deemed to occurwhen the product is shipped to the customer.

 

At the time of each transaction, Click2learnassesses whether the fee associated with its revenue is fixed and determinableand whether or not collection is probable. Click2learn assesses whether the feeis fixed and determinable based on the payment terms associated with thetransaction. If a significant portion of a fee is due after Click2learn’snormal payment terms, based upon a variable matrix such as a minimum level ofdistribution or subject to refund (other than refunds for warranty claims orits uncured defaults), Click2learn accounts for the fee as not being fixed anddeterminable. In these cases, Click2learn defers revenue and recognizes it whenit becomes due and payable.

 

Click2learn assesses the probability ofcollection based on a number of factors, including past transaction historywith the customer and the current financial condition of the customer.Click2learn does not request collateral from its customers. If Click2learndetermines at the time of the transaction that collection of a fee is notprobable, it defers revenue until payment is received.

 

For multiple element arrangements, whencompany-specific objective evidence of fair value exists for all of theundelivered elements of the arrangement, but does not exist for one or more ofthe delivered elements in the arrangement, Click2learn recognizes revenue underthe residual method. Under the residual method, at the outset of thearrangement with a customer, Click2learn defers revenue for the fair value ofits undelivered elements such as consulting services and product support andupgrades, and recognizes the revenue for the remainder of the arrangement feeattributable to the elements initially delivered, such as software licenses,when the criteria in SOP 97-2 have been met. Company-specific objectiveevidence is established for support and upgrades of standard products for whichno installation or customization is required based upon the amounts Click2learncharges when support and upgrades are sold separately. For multiple elementarrangements involving installation or customization, company-specificobjective evidence is established for support and maintenance arrangements ifits customers have an optional annual renewal rate specified in the arrangementand the rate is substantive. Company-specific objective evidence is establishedfor consulting and installation services based on the hourly rates Click2learncharges for its employees when they are performing these services providedClick2learn has the ability to accurately estimate the hours required tocomplete a project based upon its experience with similar projects.

 

Professional services revenue is recognizedfrom fixed price contracts as services are provided or by using thepercentage-of-completion method of accounting, based on the ratio of laborcosts incurred to the total estimated project cost, for individual fixed-pricecontracts. Provisions for any estimated losses on uncompleted contracts aremade in the period in which such losses become evident. Professional servicesrevenue from time and materials contracts and training services is recognizedas revenue as services are performed.

 

Click2learn recognizes revenue fromnon-refundable minimum royalty agreements from distributors or resellers upon deliveryof product to the distributor or reseller, provided no significant obligationsremain outstanding and the conditions of SOP 97-2 have been met.  If minimum royalties are exceeded, theadditional royalties are recognized as revenue when earned, based on thecontractual reporting obligations.

 

Revenue from subscriptionlicenses, hosting agreements and support agreements is recognized on astraight-line basis over the life of the contract.

 

(e) Net Loss Per Share

 

Basic net loss per share is computed by dividing the netloss by the weighted average number of common shares outstanding during theperiod.  Diluted per share amountsreflect the weighted average

 

7

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number of common and dilutive shares outstanding during the period. AsClick2learn had a net loss in each of the periods presented, basic and dilutednet loss per share are the same.

 

Excluded from the computation of diluted loss per share for the threeand nine months ended September 30, 2003 are options to acquire approximately6,010,870 shares of common stock with a weighted average exercise price of$3.73 and warrants to purchase 6,937,055 shares of common stock with a weightedaverage exercise price of $3.34 because their effects would be anti-dilutive.Options to acquire approximately 6,161,452 shares of common stock with aweighted average exercise price of $4.72 and warrants to purchase 3,633,686shares of common stock with a weighted exercise share price of $5.75 have beenexcluded from the computation of diluted earnings per share for the three andnine months ended September 30, 2002 because their effects would beanti-dilutive.

 

The change in common stock and additional paid-in capital reflects thestock option exercises and stock purchase for the Employee Stock Purchase Planon July 31, 2003.

** **

**(f) Derivative Financial Instruments**

 

Click2learn had no derivative financial instruments outstanding atSeptember 30, 2003 or December 31, 2002.

 

(g) Comprehensive Loss and Accumulated OtherComprehensive Loss

 

The following table sets forth the components ofcomprehensive loss for the periods presented below (in thousands):

 
|                                    |   | **Three  Months Ended  September 30,** |       | **Nine  Months Ended  September 30,** |       |
|-----------------------------------------|--------|----------------------------------------|------------|---------------------------------------|------------|
|                                    |   | **2003**                               |       | **2002**                              |       | **2003** |   | **2002** |   |
|                                    |   |                                   | ** ** |                                  | ** ** |   | ** ** |   | ** ** |
| Net loss                                |   | $                                      | (1,369     | )                                     | $          | (7,452 | ) | $ | (3,050 | ) | $ | (17,357 | ) |
| Foreign currency translation adjustment |   | (27                                    | )          | (27                                   | )          | 100 |   | (26 | ) |
| Total comprehensive loss                |   | $                                      | (1,396     | )                                     | $          | (7,479 | ) | $ | (2,950 | ) | $ | (17,383 | ) |

** **

**Accumulated other comprehensive loss at September30, 2003 and 2002 consists of foreign currency translation adjustments.**

 

(h)Stock-Based Compensation

 

Click2learn applies theintrinsic-value-based method of accounting prescribed by Accounting PrinciplesBoard Opinion No. 25 (“APB 25”), *Accountingfor Stock Issued to Employees,*and related interpretations includingFinancial Accounting Standards Board Interpretation No. 44 (“FIN 44”),*Accounting for Certain Transactions Involving StockCompensation, an interpretation of APB 25*, to account for itsfixed-plan stock options.  Under thismethod, compensation expense is recorded only if the current market price ofthe underlying stock exceeded the exercise price on the date of the grant.  Statement of Financial Accounting StandardsNo. 123 (“SFAS 123”), *Accounting forStock-Based Compensation*, established accounting and disclosurerequirements using a fair-value-based method of accounting for stock-basedemployee compensation plans.  As allowedby SFAS 123, Click2learn has elected to continue to apply theintrinsic-value-based method of accounting described above, and has adoptedonly the disclosure requirements of SFAS 123. The following table illustrates the effect on net loss if thefair-value-based method had been applied to all outstanding and unvested awardsin each period (in thousands):

 

8

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|                                                                                                                         |   | **Three Months Ended  September 30,** |   | **Nine Months Ended  September 30,** |   |
|------------------------------------------------------------------------------------------------------------------------------|--------|---------------------------------------|--------|--------------------------------------|--------|
|                                                                                                                         |   | **2003**                              |   | **2002**                             |   | **2003** |   | **2002** |   |
|                                                                                                                         |   |                                  |   |                                 |   |   |   |   |   |
| Net loss, as reported                                                                                                        |   | $                                     | (1,369 | )                                    | $      | (7,452 | ) | $ | (3,050 | ) | $ | (17,357 | ) |
| Add stock-based employee compensation expenses  included in reported net loss, net of tax                                    |   | —                                |   | —                               |   | — |   | 5 |   |
| Deduct total stock-based employee compensation  expense determined under fair-value-based method for all rewards, net of tax |   | $                                     | (944   | )                                    | $      | (1,239 | ) | $ | (3,145 | ) | $ | (4,322 | ) |
| Pro forma net loss                                                                                                           |   | $                                     | (2,313 | )                                    | $      | (8,691 | ) | $ | (6,195 | ) | $ | (21,674 | ) |
| Basic and diluted net loss per share:                                                                                        |   |                                  |   |                                 |   |   |   |   |   |
| As reported                                                                                                                  |   | $                                     | (0.04  | )                                    | $      | (0.30 | ) | $ | (0.11 | ) | $ | (0.71 | ) |
| Pro forma                                                                                                                    |   | $                                     | (0.07  | )                                    | $      | (0.35 | ) | $ | (0.22 | ) | $ | (0.89 | ) |

 

(i) New Accounting Policies

 

In November 2002, the EITF reached a consensus on Issue No. 00-21(“EITF 00-21”), *Revenue Arrangements withMultiple Deliverables*. EITF 00-21 addresses certain aspects of theaccounting by a vendor for arrangements under which the vendor will perform multiplerevenue generating activities.  EITF00-21 will be effective for periods beginning after June 15, 2003. The adoptionof EITF 00-21 did not have a material impact on Click2learn’s financialposition and results of operations.

 

In January 2003, the FASBissued Interpretation No. 46 (“FIN 46”), *Consolidationof Variable Interest Entities, an Interpretation of ARB No. 51.*  FIN 46 addresses the consolidation bybusiness enterprises of variable interest entities as defined in FIN 46.  FIN 46 applies immediately to variableinterests in variable interest entities created after January 31, 2003, and tovariable interests in variable interest entities obtained after January 31,2003. As amended by FASB Staff Position (“FSP”) No. FIN 46-6, FIN 46 iseffective for variable interests in a variable interest entity created beforeFebruary 1, 2003 at the end of the first interim or annual period ending afterDecember 15, 2003 (the end of fiscal 2003, December 31, 2003 for Click2learn).  Click2learn is currently reviewing thepotential impact of FIN 46 on its consolidated financial statements.

 

In April 2003, the FASBissued SFAS No. 149 (“SFAS No. 149”), *Amendmentof Statement 133 on Derivative Instruments and Hedging Activities*.  SFAS No. 149 amends and clarifies financialaccounting and reporting for derivative instruments, including certainderivative instruments embedded in other contracts (collectively referred to asderivatives) and for hedging activities under SFAS No. 133.  SFAS No. 149 is effective for contractsentered into or modified after June 30, 2003, and hedging relations designatedafter June 30, 2003, except for those provisions of SFAS No. 149, which relateto SFAS No. 133 implementation issues that have been effective for fiscalquarters that began prior to June 15, 2003. For those issues, the provisions that are currently in effect shouldcontinue to be applied in accordance with their respective effectivedates.  In addition, certain provisionsof SFAS No. 149, which relate to forward purchases or sales of when-issuedsecurities or other securities that do not yet exist, should be applied to bothexisting contracts and new contracts entered into after June 30, 2003.  The adoption of SFAS No. 149 did not have amaterial effect on Click2learn’s financial statements.

 

In May 2003, the FASBissued SFAS No. 150 (“SFAS No. 150”), *Accountingfor Certain Instruments with Characteristics of both Liabilities and Equity*.  SFAS No. 150 establishes standards for howan issuer classifies and measures certain financial instruments withcharacteristics of both liabilities and equity.  SFAS No. 150 requires that an issuer classify a financialinstrument that is within the scope of SFAS No. 150 as a liability.  SFAS No. 150 is effective for financialinstruments entered into or modified

 

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after May 31, 2003, and otherwise is effective forClick2learn beginning September 1, 2003.  The adoption of SFAS No. 150 did not have a material effect onClick2learn’s financial statements.

 

In July 2003, the EITFreached a consensus on Issue 03-5 (“EITF 03-5”), *Applicability of AICPA Statement of Position 97-2 “Software RevenueRecognition” (SOP 97-2) to Non-Software Deliverables*.  The consensus was reached that non-softwaredeliverables are included within the scope of SOP 97-2 if they are included inan arrangement that contains software that is essential to the non-softwaredeliverables’ functionality.  Thisconsensus is effective at the beginning of the first interim period beginningafter August 13, 2003.  Click2learn doesnot expect the adoption of EITF 03-5 to have a material impact on its financialposition or results of operations.

 

In July 2003, the EITFreached a consensus on Issue 03-7 (“EITF 03-7”), *Accounting for the Settlement of the Equity-Settled Portion of aConvertible Debt Instrument that Permits or Requires the Conversion Spread tobe Settled in Stock (Instrument C of EITF Issue No. 90-19, “Convertible Bondswith Issuer Option to Settle for Cash upon Conversion”)*.  The consensus was reached that uponsettlement of a security with the characteristics of Instrument C in Issue90-19 by payment of the accreted value of the obligation (recognized liability)in cash and settlement of the conversion spread (unrecognized equityinstrument) with stock, only the cash payment should be considered in thecomputation of gain or loss on extinguishment of the recognized liability.  That is, any shares transferred to settlethe embedded equity instrument (referred to as the excess conversion spread inIssue 90-19) would not be considered in the settlement of the debtcomponent.  This consensus is effectivefor settlement transactions entered into on or after the beginning ofClick2learn’s first interim period beginning after August 13, 2003.  Click2learn does not expect the adoption ofEITF 03-7 to have a material impact on its financial position or results ofoperations.

 

(j)Reclassifications

 

Amortizationof purchased technology has been reclassified, as follows, from research anddevelopment costs to platform cost of revenue since it relates to productscurrently being sold by Click2learn:  

 
|                                  |   | **For the three months  ended September 30,** |   | **For the nine months ended   September 30,** |   |
|---------------------------------------|--------|-----------------------------------------------|--------|-----------------------------------------------|--------|
|                                  |   | **2003**                                      |   | **2002**                                      |   | **2003** |   | **2002** |   |
|                                  |   |                                          |   |                                          |   |   |   |   |   |
| Amortization  of purchased technology |   | $                                             | 353    |                                          | $      | 117 |   | $ | 823 |   | $ | 350 |   |
|                                       |        |                                               |        |                                               |        |  |  |  |  |  |  |  |  |

 

**NOTE 2:  DISCONTINUED OPERATIONS**

 

During January 2002, Click2learn sold certain assets of its contentdevelopment business, including equipment and a customer list to NIIT (USA),Inc. (“NIIT”), the U.S. operations of NIIT Limited, a global custom softwaredevelopment firm, under an Asset Purchase agreement for $1 million, resultingin a gain of $927,000 based on the book value of those assets. As a result ofthe transaction with NIIT, Click2learn significantly reduced the headcount ofits custom content development business and closed certain facilities.  During the third quarter of 2002,Click2learn completed the discontinuation of its remaining custom contentdevelopment business by early termination of its contract to develop contentfor the Washington Army National Guard. As part of the negotiation to terminatethe contract, Click2learn agreed to forego the collection of $4.5 million inaccounts receivable.    Results relatedto its custom content development business for the year ended December 31, 2002and prior years have been reclassified as income (loss) from discontinuedoperations.

 

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Summary operating results of the discontinuedoperations were as follows (in thousands):

 
|                               |   | **For the Three  Months Ended  September 30, 2002** |   | **For the Nine  Months Ended  September 30, 2002** |   |
|------------------------------------|--------|-----------------------------------------------------|--------|----------------------------------------------------|--------|
| Revenues                           |   | $                                                   | — |                                               | $      | 248 |   |
| Cost of revenues                   |   | $                                                   | (474   | )                                                  | $      | (2,717 | ) |
| Operating expenses                 |   | $                                                   | (4,475 | )                                                  | $      | (6,058 | ) |
| Other income                       |   | $                                                   | — |                                               | $      | 927 |   |
| Loss from  discontinued operations |   | $                                                   | (4,949 | )                                                  | $      | (7,600 | ) |

 

**NOTE3:  BANK CREDIT FACILITY**

 

In December 2002, Click2learn consolidatedits existing $4 million working capital line of credit and $1 million term loanfacility with Silicon Valley Bank into a $10 million working capital line.  Under the facility Click2learn will continueto repay the remaining balance of the term loan in accordance with the originalterms (monthly payments of $41,666.67 plusinterest ending October 1, 2003), but the unpaid balance of the term loan willnot be available under the line of credit. The term loan and the working capital line will bear interest at thegreater of Silicon Valley Bank prime rate plus 2.25% or 7.0% and have minimummonthly interest of $8,500 per month regardless of the loan balances.

 

The credit facility is collateralized by asecurity interest in all of Click2learn’s assets.  Covenants in the loan agreements include restrictions onClick2learn’s ability to pay dividends or make other distributions, makeacquisitions or investments, merge or consolidate with others or dispose ofassets, as well as financial covenants limiting the amount of net losses duringany three month period and requiring Click2learn to maintain certain levels ofminimum tangible net worth.  If notrenewed, the working capital line terminates and any advances made are due onDecember 6, 2004.

 

Under the working capitalline of credit, the principal amount of $3,603,251 was outstanding as ofSeptember 30, 2003.  Borrowings outstandingunder the term loan were $41,667 at September 30, 2003 all of which isrepayable in 2003.  As of September 30,2003, Click2learn was in compliance with the loan’s covenants.** **Aggregate short-term debt of $3.6 million at September 30, 2003 ispresented net of debt discount of $111,000 attributable to the issuance ofcommon stock warrants.

 

**NOTE 4: GUARANTEES**

 

Click2learn adopted FIN 45 during the quarter ended December 31,2002.  In the ordinary course ofbusiness, Click2learn is not subject to potential obligations under guaranteesthat fall within the scope of FIN 45 except for standard indemnification andwarranty provisions that are contained within many of our customer license andservice agreements, and give rise only to the disclosure requirementsprescribed by FIN 45*.*

 

Indemnificationand warranty provisions contained within our customer license and serviceagreements are generally consistent with those prevalent in our industry.  The duration of our product warrantiesgenerally does not exceed 90 days following delivery of our products.  We have not incurred significant obligationsunder customer indemnification or warranty provision historically and do notexpect to incur significant obligations in the future.  Accordingly, we do not maintain accruals forpotential customer indemnification or warranty-related obligations.

 

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**NOTE 5:  SEGMENT INFORMATION**

 

Click2learn’s internalreporting includes the three reportable segments:  Platforms, Tools, and Content Services.  Platforms revenue includes software licenses, subscription andhosting fees, implementation, customization, consulting, training and supportrelated to the Aspen suite,  theIngenium learning management system, which is the precursor product to theAspen Learning Management Server, and the e-Learning Network, which is nolonger offered to new customers. Tools revenue includes software licenses,technical support and training related to the ToolBook line of products.  Content Services revenue includes theplacement of Click2learn personnel at customer sites on a time and materialbasis, the resale of third party off the shelf training content and license andhosting fees for our Rapid e-Learning Development System, which is no longeroffered to new customers.

 

Click2learn’s operating committee, whichincludes its Chief Executive Officer and Chief Financial Officer, has beenidentified as the Chief Operating Decision Maker (CODM) as it assesses theperformance of the business units and decides how to allocate resources to thebusiness units.  Segment income is themeasure of profit and loss that the CODM uses to assess performance and makedecisions.  Segment income representsrevenue less cost of revenue incurred within the operating segments aspresented in Click2learn’s consolidated statements of operations.  Click2learn does not allocate operatingexpenses including research and development, sales and marketing, general andadministrative, or amortization of goodwill to its operating segments.  In addition, other income (expense) are notallocated to operating segments.

 

There is no intersegment revenue.  Click2learn’s CODM does not review totalassets or depreciation and amortization by operating segment.  The accounting policies for reportedsegments are the same as Click2learn as a whole.

 

Revenues by geographic region which are basedon the location of the customers are as follows (in thousands):

 
|     |   | **For the  Three  Months Ended  September 30,** |   | **For the  Nine  Months Ended  September 30,** |   |
|----------|--------|-------------------------------------------------|--------|------------------------------------------------|--------|
|     |   | **2003**                                        |   | **2002**                                       |   | **2003** |   | **2002** |   |
| Revenue: |   |                                            |   |                                           |   |   |   |   |   |
| US       |   | $                                               | 6,727  |                                           | $      | 6,404 |   | $ | 20,732 |   | $ | 19,838 |   |
| UK       |   | 323                                             |   | 56                                             |   | 1,548 |   | 538 |   |
| Other    |   | 463                                             |   | 479                                            |   | 1,363 |   | 1,475 |   |
|     |   | $                                               | 7,513  |                                           | $      | 6,939 |   | $ | 23,643 |   | $ | 21,851 |   |

 

Long-lived assets by geographic location are as follows (in thousands):

 
|               |   | **September  30,  2003** |   | **December  31,  2002** |   |
|--------------------|--------|--------------------------|--------|-------------------------|--------|
| Long-lived assets: |   |                     |   |                    |   |
| US                 |   | $                        | 7,204  |                    | $      | 8,596 |   |
| Other              |   | 236                      |   | 131                     |   |
|               |   | $                        | 7,440  |                    | $      | 8,727 |   |

 

Long-lived assets represent property, plant, andequipment, goodwill and other intangible assets, net of accumulateddepreciation and amortization.

 

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**NOTE 6:  SUBSEQUENT EVENTS**

 

On October 20, 2003, Click2learn entered intoan Agreement and Plan of Reorganization with Docent, Inc, which was approved byClick2learn’s board of directors.  Underthe terms of the agreement, Click2learn and Docent will be acquired by a newcorporate entity.  Stockholders ofClick2learn will receive 0.4144 shares in the new company for each common shareheld on the closing date or approximately 52% of the total outstanding commonstock of the new company, without taking into account the exercise of optionsprior to the closing date.  Stockholdersof Docent will receive .9525 shares of common stock in the new company for eachcommon share held on the closing date, or approximately 48% of the totaloutstanding common stock of the new company, without taking into account theexercise of options prior to the closing date. Outstanding options and warrants will be converted into options andwarrants for the purchase of shares in the new corporation in accordance withthe same exchange ratio.  Thetransaction is anticipated to be a tax-free reorganization and/or a tax-freeexchange for income tax purposes.  Theconsummation of the merger is subject to the approval of Click2learn’sstockholders and the stockholders of Docent and other customary closingconditions.

 

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**Item 2****.  Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

 

*This Quarterly Report includes“forward-looking statements” within the meaning of the Private SecuritiesLitigation Reform Act of 1995. This Act provides a “safe harbor” forforward-looking statements to encourage companies to provide prospectiveinformation about themselves so long as they identify these statements asforward-looking and provide meaningful cautionary statements identifyingimportant factors that could cause actual results to differ from the projectedresults. All statements other than statements of historical fact we make inthis Quarterly Report are forward-looking. Such forward-looking statementsinvolve risks and uncertainties, including, among other things, statementsregarding our anticipated costs and expenses and revenue mix. Suchforward-looking statements include, among others, those statements includingthe words “expect”, “anticipate”, “intend”, “believe” and similar language. Ouractual results may differ significantly from those projected in the forward-lookingstatements. Factors that might cause or contribute to such differences include,but are not limited to those discussed in the section “Management’s Discussionand Analysis of Financial Condition and Results of Operations — Factors ThatMay Affect Future Results of Operations.” You are cautioned not to place unduereliance on the forward-looking statements, which speak only as of the date ofthis Quarterly Report on Form 10-Q. We undertake no obligation to publiclyrelease any revisions to the forward-looking statements or reflect events orcircumstances after the date of this document.*

 

**Overview**

 

We are a leading developer and provider ofenterprise learning solutions for companies, government agencies andeducational institutions. We design, develop, market, license and support anintegrated suite of enterprise software products and related services thatallow our customers to cost-effectively create, personalize and manage thedelivery of learning and knowledge content. Our flagship product, the AspenEnterprise Productivity Suite, combines collaborative content development,comprehensive learning management and virtual classroom systems into a single,integrated product suite with a unified architecture and user experience. Weprovide our products and services to customers across a broad range ofindustries including financial services, accounting, healthcare, insurance,technology, manufacturing, telecommunications, transportation, utilities,government and education.

 

We report revenue in three separatecategories related to the different components of our business:

 

•                        Platforms revenue includes software licenses,subscription and hosting fees, implementation, customization, consulting,training and support related to the Aspen suite, our Ingenium learningmanagement system, which is the precursor product to the Aspen LearningManagement Server, and our e-Learning Network, which is no longer offered tonew customers.

•                        Tools revenue includes software licenses,technical support and training related to our ToolBook line of products.

•                        Content Services revenue includes the placementof Click2learn personnel at customer sites on a time and material basis, theresale of third party off the shelf training content and license and hostingfees for our Rapid e-Learning Development System, which is no longer offered tonew customers.  During 2002 wediscontinued our custom content development business, which had been theprimary source of revenue from Content Services in prior years.  Prior year’s revenue and expenses for thisportion of the business have been reclassified as income or loss fromdiscontinued operations.

 

## **Recent Developments**

## ** **

On October 20, 2003, we announced anagreement to combine with Docent, Inc. (“Docent”) in a merger of equals transaction.  The proposed transaction is anticipated toclose in the first quarter of 2004.  Theannouncement of the transaction and our actions taken in preparing for thesubmission of the transaction to the stockholders and in planning for theintegration with Docent may impact our results of

 

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operations and liquidity in futureperiods.  For more information on theproposed merger see “Other Information” on page 32 and for more information onthe risks associated with the merger agreement see “Factors That May AffectFuture Results of Operations” on page 22.  Inconnection with the proposed merger, Docent and we expect to file a joint proxystatement/prospectus with the Securities and Exchange Commission.  The joint proxy statement/prospectus will bemailed to all holders of our stock and will contain important information aboutus, Docent and the proposed transaction, risks relating to the transaction andthe combined company, and related matters. We urge all of our stockholders to read the joint proxystatement/prospectus when it becomes available.

 

## **Critical Accounting Policies and Estimates**

## ** **

Our critical accounting policies andestimates are as follows:

 

•                       Revenue recognition

•                       Estimating allowances for sales returns and theallowance for doubtful accounts

•                       Valuation of goodwill

•                       Valuation of long-lived assets

 

*Revenue Recognition.*We recognize revenue pursuant to the requirementsof Statement of Position No. 97-2, *SoftwareRevenue Recognition* (“SOP 97-2”), as amended by Statement ofPosition No. 98-9, *Software RevenueRecognition with Respect to Certain Arrangements.* Under SOP 97-2,revenue attributable to an element in a customer arrangement is recognized whenpersuasive evidence of an arrangement exists and delivery has occurred,provided the fee is fixed or determinable, collectibility is probable and thearrangement does not require significant customization of the software.

 

For all sales, we use either a bindingpurchase order or signed agreement, depending on the nature of the transaction,as evidence of an arrangement. Sales through our significant resellers areevidenced by a master agreement governing the relationship.

 

For software license fees in single elementarrangements and multiple element arrangements, which do not includecustomization or consulting services, delivery typically is deemed to occurwhen the product is shipped to customers.

 

At the time of each transaction, we assesswhether the fee associated with our revenue is fixed and determinable andwhether or not collection is probable. We assess whether the fee is fixed anddeterminable based on the payment terms associated with the transaction. If asignificant portion of a fee is due after our normal payment terms, based upona variable matrix such as a minimum level of distribution or subject to refund(other than refunds for warranty claims or our uncured defaults), we accountfor the fee as not being fixed and determinable. In these cases, we deferrevenue and recognize it when it becomes due and payable.

 

We assess the probability of collection basedon a number of factors, including past transaction history with the customerand the current financial condition of the customer. We do not requestcollateral from our customers. If we determine at the time of the transactionthat collection of a fee is not probable, we defer revenue until payment isreceived.

 

For multiple element arrangements, whencompany-specific objective evidence of fair value exists for all of theundelivered elements of the arrangement, but does not exist for one or more ofthe delivered elements in the arrangement, we recognize revenue under theresidual method. Under the residual method, at the outset of the arrangementwith a customer, we defer revenue for the fair value of its undeliveredelements such as consulting services and product support and upgrades, andrecognize the revenue for the remainder of the arrangement fee attributable tothe elements initially delivered, such as software licenses, when the criteriain SOP 97-2 have been met. Company-specific objective evidence is establishedfor support and upgrades of standard products for which no installation orcustomization is required based

 

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upon the amounts we charge when support andupgrades are sold separately. For multiple element arrangements involvinginstallation or customization, company-specific objective evidence isestablished for support and maintenance arrangements if our customers have anoptional annual renewal rate specified in the arrangement and the rate issubstantive. Company-specific objective evidence is established for consultingand installation services based on the hourly rates we charge for our employeeswhen they are performing these services provided we have the ability toaccurately estimate the hours required to complete a project based upon ourexperience with similar projects.

 

Professional services revenue is recognizedfrom fixed price contracts as services are provided or by using thepercentage-of-completion method of accounting, based on the ratio of laborcosts incurred to the total estimated project cost, for individual fixed-pricecontracts. Provisions for any estimated losses on uncompleted contracts aremade in the period in which such losses become evident. Professional servicesrevenue from time and materials contracts and training services is recognizedas revenue as services are performed.

 

We recognize revenue from non-refundableminimum royalty agreements from distributors or resellers upon delivery ofproduct to the distributor or reseller, provided no significant obligationsremain outstanding and the conditions of SOP 97-2 have been met.  If minimum royalties are exceeded, theadditional royalties are recognized as revenue when earned, based on thecontractual reporting obligations.

 

Revenue from subscription licenses, hostingagreements and support agreements is recognized on a straight-line basis overthe life of the contract.

 

*Allowances for Sales Returns and DoubtfulAccounts.*Thepreparation of financial statements requires us to make estimates andassumptions that affect the reported amount of assets and disclosure ofcontingent assets and liabilities at the date of the financial statements andthe reported amounts of revenue and expenses during the reported period.Specifically, we must make estimates of future product returns related tocurrent period product revenue. We analyze historical returns, current economictrends, and changes in customer demand and acceptance of our products whenevaluating the adequacy of the sales returns and other allowances. Significantjudgments and estimates must be made and used in connection with establishingreserves for sales returns and the allowance for doubtful accounts in anyaccounting period. Material differences may result in the amount and timing ofour revenue for any period if we made different judgments or utilized differentestimates. Similarly, we must make estimates of the uncollectability of ouraccounts receivable. We specifically analyze accounts receivable greater than90 days and analyze historical bad debts, customer concentrations, customercredit-worthiness and current economic trends when evaluating the adequacy ofthe allowance for doubtful accounts.

 

*Valuation of Goodwill.*We assess the impairment of goodwill on an annualbasis or whenever events or changes in circumstances indicate the fair value ofa reporting unit to which goodwill relates is less than its carrying value.Factors we consider important which could trigger an impairment review includepoor economic performance relative to expected historical or projected futureoperating results, significant negative industry, economic or company specifictrends and changes in the manner of our use of the assets or the plans for ourbusiness. If we were to determine that the fair value of a reporting unit wasless than its carrying value, including goodwill based upon the annual test orthe existence of one or more of the above indicators of impairment, then wewould measure impairment based on a comparison of the implied fair value ofreporting unit goodwill with the carrying amount of goodwill. The implied fairvalue of goodwill is determined by allocating the fair value of a reportingunit to its assets (recognized and unrecognized) and liabilities in a mannersimilar to a purchase price allocation. The residual fair value after thisallocation is the implied fair value of reporting unit goodwill. To the extentthe carrying amount of reporting unit goodwill is greater than the implied fairvalue of reporting unit goodwill, we would record an impairment charge for thedifference.

 

*Valuation of Long Lived Assets.*  SFAS 144 provides a single accounting modelfor disposal of long-lived assets. SFAS 144 also changes the criteria forclassifying an asset as held for sale and broadens the scope of businesses tobe disposed of that qualify for reporting as discontinued operations andchanges

 

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the timing of recognizing losses on such operations. We adopted SFAS144 on January 1, 2002.  Theadoption of SFAS 144 did not affect our consolidated financial position orresults of operations as of January 1, 2002. The broadened definition of discontinued operations with SFAS 144 hasaffected the presentation and disclosure of our results of operations for theyear ended 2002 and prior years presented for comparison. In accordance withSFAS 144, we review long-lived assets, such as property, plant, and equipment,and purchased intangibles subject to amortization, for impairment wheneverevents or changes in circumstances indicate that the carrying amount of anasset may not be recoverable. We measure recoverability of assets to be heldand used by comparing the carrying amount of an asset to estimated undiscountedfuture cash flows expected to be generated by the asset. If the carrying amountof an asset exceeds its estimated future cash flows, we recognize an impairmentcharge as the amount by which the carrying amount of the asset exceeds the fairvalue of the asset. Assets to be disposed of would be separately presented inthe balance sheet and reported at the lower of the carrying amount or fairvalue less costs to sell, and are no longer depreciated.  The assets and liabilities of a disposalgroup classified as held for sale would be presented separately in theappropriate asset and liability sections of the balance sheet.

 

# **Results of Operations for the Three and Nine MonthsEnded September 30, 2003 Compared to the Three and Nine Months Ended September30, 2002**

# ** **

In accordance with Statement of FinancialAccounting Standards No. 144, *Accounting forthe Impairment and Disposal of Long-lived Assets*, the financialstatements and management’s discussion and analysis present results fromcontinuing operations with revenue and expenses related to our discontinuedcustom content development business as loss from discontinued operations.  See “Loss from Discontinued Operations” foradditional information regarding the discontinuance of the custom contentdevelopment business and the amount of revenue and costs that have beenreclassified to loss from discontinued operations.

 

*Revenue. *For the three and nine-month periods endedSeptember 30, 2003 total revenue increased 8% in each period to $7.5 millionand $23.6 million as compared to $6.9 million and $21.9 million for thecomparable periods ended September 30, 2002. The increase in revenue is attributed to revenue growth from the Platformscategory offset by declining revenue from the Tools and Content Servicescategories.

 

Platforms revenue grew 22% in each period to $6.4 million and $19.9million for the three and nine-month periods ended September 30, 2003 ascompared to $5.3 million and $16.2 million for the comparable periods endedSeptember 30, 2002.  This growth isattributable to existing clients purchasing additional Aspen licenses orservices as well as new clients purchasing initial Aspen licenses and services.  We believe that future growth in totalrevenue is dependent on continuing to increase Platforms revenue.

 

Tools revenue declined 26% and 34% to $672,000 and $2.2 million for thethree and nine-month periods ended September 30, 2003 as compared to $907,000and $3.4 million for the comparable periods ended September 30, 2002.   While new product releases may result inincreased customer demand and higher Tools revenue in future periods, webelieve that Tools revenue will continue to decline in future periods if new releasesof the products are not met with renewed customer demand.

 

Content Services revenue declined 46% and 30% to $398,000 and $1.5million for the three and nine-month periods ended September 30, 2003 ascompared to $737,000 and $2.2 million for the comparable periods endedSeptember 30, 2002.  Current ContentServices revenue is derived primarily from the placement of temporary personnelat our clients’ locations on an hourly basis. Due to the economic downturn, demand for temporary labor resources,which is typically lower in the summer months, is down overall.  We expect Content Services revenue to remainat current levels or continue to decline in future periods.

 

International revenues for the three and nine month periods endedSeptember 30, 2003 represented 11% and 9% respectively.  The increase in percent of revenue relatedto the three-month period was due

 

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primarily to lower overall revenue in the period as compared to thefirst two quarters of 2003 and not due to a significant increase ininternational revenues.

 

*Cost of Revenue*.  For the three and nine-month periods endedSeptember 30, 2003 total cost of revenue increased 9% and decreased 4% to $2.3million and $7.1 million as compared to $2.2 million and $7.4 million for thesame periods ended September 30, 2002. The increase over the respective three-month periods is primarily due toincreased Platforms costs resulting from higher Platforms revenue and costsrelated to amortization of purchased technology, offset by decreases in Toolsand Content Services costs as a result of lower revenue over theseperiods.   The decrease over therespective nine-month periods is primarily due to declines in Tools and ContentServices costs as a result of lower revenue, offset by increased costs relatedto our Platform revenue.

 

Platform cost of revenue increased 39% and 16% to $1.8 million and $5.3million for the three and nine-month periods ended September 30, 2003 ascompared to $1.3 million and $4.6 million for the same periods ended September 30,2002.  The increase was due to higherPlatform revenue and increased costs related to the amortization of purchasedtechnology, which increased substantially over the three-month period endedSeptember 30, 2003.   Platform cost ofrevenue as a percentage of Platform revenue was 28% and 27% for the three andnine-month periods ended September 30, 2003 up from 25% and down from 28% forthe same periods ended September 30, 2002. The increase in costs as a percentage of revenue over the respectivethree-month periods was due primarily to increased costs for amortization ofpurchased technology to $353,000 for the quarter ended September 30, 2003reflecting additional amortization related to our Virtual Classroom Serverproduct.  This was up from $117,000 ofamortization in the prior year period related solely to technology acquiredthrough the purchase of Intelliprep. The decline in costs as a percentage of revenue over the respectivenine-month periods was due to reduced labor costs on the services portion ofPlatforms revenue resulting from performing some of this work using ouroperations in Hyderabad, India where comparable labor rates are lower, offsetby increased costs from amortization of the purchased VCS technology during thelast six months.

 

Tools cost of revenue declined 48% and 58% to $140,000 and $398,000 forthe three and nine-month periods ended September 30, 2003 as compared to$268,000 and $950,000 for the same periods ended September 30, 2002.  The decline is a result of lower Toolsrevenue.  Tools cost of revenue as apercentage of Tools revenue was 21% and 18% for the three and nine-monthperiods ended September 30, 2003 down from 30% and 28% for the same periodsended September 30, 2002.  The declinein costs as a percentage of revenue was due primarily to the mix of licensesand services and lower costs of providing training services.

 

Content Services cost of revenue declined 34% and 26% to $383,000 and$1.4 million for the three and nine-month periods ended September 30, 2003 ascompared to $577,000 and $1.9 million for the same periods ended September 30,2002.  The decline is a result of lowerContent Services revenue. Content cost of revenue as a percentage of ContentServices revenue was 96% and 90% for the three and nine-month periods endedSeptember 30, 2003 up from 78% and 85% for the same periods ended September 30,2002.  The increase in costs as apercentage of revenue was due primarily to a lower revenue base with which toabsorb the group’s fixed overhead.

 

**Operating Expenses**

 

*Research and Development*.  For the three and nine-month periods endedSeptember 30, 2003 total research and development cost declined 10% and 27% to$1.7 million and $4.7 million as compared to $1.9 million and $6.4 million forthe same periods ended September 30, 2002. The decline is a result of cost cutting measures taken in the secondhalf of 2002 that resulted in lower headcount in the United States and theestablishment of research and development operations in Hyderabad, India wherelabor costs are lower than in the United States. We anticipate that researchand development costs will increase during the remainder 2003 as a result ofincreased staffing necessary for upcoming releases of the Aspen platform.  In prior periods we had classified the amortizationof purchased technology as research and development

 

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costs.  The costs of thisamortization have been reclassified as cost of Platforms revenue for thecurrent and historical periods reported.

 

*Sales and Marketing.* For the three and nine-month periods endedSeptember 30, 2003 total sales and marketing cost declined 10% and 19% to $3.3million and $10.5 million as compared to $3.7 million and $13.0 million for thesame periods ended September 30, 2002. The decline is a result of cost cutting measures taken in the secondhalf of 2002 that resulted in lower sales and marketing headcount as well as reduced advertising costs over thecomparable periods.

 

*General and Administrative.* Total general and administrative costincreased 24% to $1.5 million as compared to $1.2 million for the three-monthperiod ended September 30, 2003 as compared to the same period the prior year,while costs for the nine-month period ended September 30, 2003 were unchangedfrom the same period in the prior year at $4.2 million.  The increase is the result of higher legaland accounting fees as well as an increase in salary expense as compared to theprior period ended September 30, 2002. We expect general and administrative costs to increase in the comingperiod as a result of expenses incurred in connection with our proposed mergerwith Docent, regardless of the consummation of the transaction.

 

*Other Income (Expense).*  For the three and nine-months endedSeptember 30, 2003 other expenses were $8,000 and $101,000.  These amounts were primarily interest onborrowing from Silicon Valley Bank.   For the three and nine-months endedSeptember 30, 2002, other income was $15,000 and $28,000, which was netinterest income.

 

*Equity inLosses of Affiliate*.  Losses from affiliates relate to our jointventure with Softbank in Japan, Click2learn Japan KK.  We use the equity method of accounting whereby we record ourownership portion of the joint ventures net income or loss.  For the three and nine month periods endedSeptember 30, 2003 our losses from affiliates were $25,000 and $75,000 comparedto $25,000 and $175,000 for the periods ended September 30, 2002.

 

*Loss fromDiscontinued Operations*.  In 2003 we have not had lossesfrom discontinued operations.  For thethree and nine month periods ended September 30, 2002 losses from thediscontinuation of our custom development business were $4.9 million and $7.6million respectively.

 

*Income Taxes*.  For thethree and nine months ended September 30, 2003, we recorded income tax expenseof $8,000 and $26,000 related to foreign income taxes.  For the three and nine months endedSeptember 30, 2002, no income tax expense was recorded.

 

**RecentAccounting Pronouncements**

 

In November 2002, the EITF reached a consensus on Issue No. 00-21(“EITF 00-21”), *Revenue Arrangements withMultiple Deliverables*. EITF 00-21 addresses certain aspects of theaccounting by a vendor for arrangements under which the vendor will performmultiple revenue generating activities. EITF 00-21 will be effective for periods beginning after June 15, 2003.The adoption of EITF 00-21 did not have a material impact on Click2learn’sfinancial position and results of operations.

 

In January 2003, the FASBissued Interpretation No. 46 (“FIN 46”), *Consolidationof Variable Interest Entities, an Interpretation of ARB No. 51.*  FIN 46 addresses the consolidation bybusiness enterprises of variable interest entities as defined in FIN 46.  FIN 46 applies immediately to variableinterests in variable interest entities created after January 31, 2003, and tovariable interests in variable interest entities obtained after January 31,2003. As amended by FASB Staff Position (“FSP”) No. FIN 46-6, FIN 46 iseffective for variable interests in a variable interest entity created beforeFebruary 1, 2003 at the end of the first interim or annual period ending afterDecember 15, 2003 (the end of fiscal 2003, December 31, 2003 forClick2learn).  Click2learn is currentlyreviewing the potential impact of FIN 46 on its consolidated financialstatements.

 

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In April 2003, the FASBissued SFAS No. 149 (“SFAS No. 149”), *Amendmentof Statement 133 on Derivative Instruments and Hedging Activities*.  SFAS No. 149 amends and clarifies financialaccounting and reporting for derivative instruments, including certainderivative instruments embedded in other contracts (collectively referred to asderivatives) and for hedging activities under SFAS No. 133.  SFAS No. 149 is effective for contractsentered into or modified after June 30, 2003, and hedging relations designatedafter June 30, 2003, except for those provisions of SFAS No. 149, which relateto SFAS No. 133 implementation issues that have been effective for fiscalquarters that began prior to June 15, 2003. For those issues, the provisions that are currently in effect shouldcontinue to be applied in accordance with their respective effective dates.  In addition, certain provisions of SFAS No.149, which relate to forward purchases or sales of when-issued securities orother securities that do not yet exist, should be applied to both existingcontracts and new contracts entered into after June 30, 2003.  The adoption of SFAS No. 149 did not have amaterial effect on Click2learn’s financial statements.

 

In May 2003, the FASBissued SFAS No. 150 (“SFAS No. 150”), *Accountingfor Certain Instruments with Characteristics of both Liabilities and Equity*.  SFAS No. 150 establishes standards for howan issuer classifies and measures certain financial instruments withcharacteristics of both liabilities and equity.  SFAS No. 150 requires that an issuer classify a financialinstrument that is within the scope of SFAS No. 150 as a liability.  SFAS No. 150 is effective for financialinstruments entered into or modified after May 31, 2003, and otherwise iseffective for Click2learn beginning September 1, 2003.   The adoption of SFAS No. 150 did not have amaterial effect on Click2learn’s financial statements.

 

In July 2003, the EITFreached a consensus on Issue 03-5 (“EITF 03-5”), “Applicability of AICPAStatement of Position 97-2 “Software Revenue Recognition” (SOP 97-2) toNon-Software Deliverables”.  Theconsensus was reached that non-software deliverables are included within thescope of SOP 97-2 if they are included in an arrangement that contains softwarethat is essential to the non-software deliverables’ functionality.  This consensus is effective at the beginningof the first interim period beginning after August 13, 2003.  Click2learn does not expect the adoption ofEITF 03-5 to have a material impact on its financial position or results ofoperations.

 

In July 2003, the EITFreached a consensus on Issue 03-7 (“EITF 03-7”), “Accounting for the Settlementof the Equity-Settled Portion of a Convertible Debt Instrument that Permits orRequires the Conversion Spread to be Settled in Stock (Instrument C of EITFIssue No. 90-19, “Convertible Bonds with Issuer Option to Settle for Cash uponConversion”)”.  The consensus wasreached that upon settlement of a security with the characteristics ofInstrument C in Issue 90-19 by payment of the accreted value of the obligation(recognized liability) in cash and settlement of the conversion spread(unrecognized equity instrument) with stock, only the cash payment should beconsidered in the computation of gain or loss on extinguishment of therecognized liability.  That is, anyshares transferred to settle the embedded equity instrument (referred to as theexcess conversion spread in Issue 90-19) would not be considered in thesettlement of the debt component.  Thisconsensus is effective for settlement transactions entered into on or after thebeginning of Click2learn’s first interim period beginning after August 13,2003.  Click2learn does not expect theadoption of EITF 03-7 to have a material impact on its financial position orresults of operations.

 

## **Liquidity and Capital Resources**

## ** **

At September 30, 2003, our principal sourceof liquidity was $14.9 million of cash and $9.4 million of accounts receivable,up from $3.6 million of cash and down from $10.8 million of accounts receivableon December 31, 2002.  The change incash is due primarily to the sale of common stock and warrants in June of 2003that resulted in net cash proceeds of approximately $11.9 million.  The change in accounts receivable is dueprimarily to improved collection efforts and the write-off of a receivable ofapproximately $500,000 from an international customer.  We believe our risk on currentPlatform-related receivables is low given the general financial strength of ourcustomers.  At September 30, 2003 we had no significant collectibility or billingproblems with any major customers or classes of customers.

 

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Although we have not made any significantchanges in our payment terms, as a result of the discontinuance of our customcontent development business we are able to collect more quickly on ourreceivables generally than in prior periods, when a significant portion of ourrevenue was from custom content development contracts.  This is because a typical custom developmentcontract was invoiced on the achievement of contract milestones, althoughrevenue was recognized using the percentage of completion method as theservices were performed.  As a result,there was often significant time elapsed between the performance of theservices and invoicing the client. Thus, the receivables from such contracts remained uncollected forlonger periods than those from software licenses or other services.  While we expect to be able to collect on ourreceivables more quickly going forward, we may offer extended payment terms tocustomers in certain circumstances from time to time.  To the extent that we offer such extended payment terms, theywill result in a longer collection period for accounts receivable and slowercash inflows from operations.

 

Based on our current cash balance, we anticipate that our cash and cashequivalents will be sufficient to meet our working capital needs and capitalexpenditures for at least the next 12 months.  However, we will continue to monitorour cash and liquidity and will seek additional financing or make additionalexpense reductions if it becomes required.

 

Net cash used for continuing operating activities was $740,000 in thenine months ended September 30, 2003 down from $2.2 million for the same period2002.  The change was due primarily toincreased revenue and lower overall expenses in 2003 as compared to 2002.

 

Net cash used in investing activities was $652,000 in the nine monthsended September 30, 2003.  Net cash usedin investing activities was primarily used for purchases of equipment at ourIndia office. As of September 30, 2003, we had no material commitments forcapital expenditures and had commitments under non-cancelable operating leaseswith terms in excess of one year of $5.8 million through 2008.

 

Cash provided by financing activities was $12.6 million in the ninemonths ended September 30, 2003, resulting primarily from draws against theSilicon Valley Bank credit facility, net of payments on debt, of approximately$351,000; net cash proceeds of approximately $11.9 million from the sale ofcommon stock and warrants in June; and approximately $373,000 received frompurchases under our Employee Stock Purchase Plan and stock option exercises.Cash from borrowings was approximately $21.6 million, while cash used forpayments on debt was $21.3 million in the nine months ended September 30, 2003.

 

In December 2002 we consolidated our existing $4 million workingcapital line of credit and $1 million term loan facility with Silicon ValleyBank into a $10 million working capital line. Under the facility we will continue to repay the remaining balance ofthe term loan in accordance with the original terms (monthly payments of$41,666.67 plus interest endingOctober 1, 2003), and the unpaid balance of the term loan will not be availablefor new loans under the line of credit. The term loan and the working capital line will bear interest at thegreater of Silicon Valley Bank prime rate plus 2.25% or 7.0% and have minimummonthly interest of $8,500 per month regardless of the loan balances.  The credit facility is collateralized by asecurity interest in all of our assets. Covenants in the loan agreements include restrictions on our ability topay dividends or make other distributions, make acquisitions or investments,merge or consolidate with others or dispose of assets, as well as financialcovenants limiting the amount of net losses during any three-month period andrequiring us to maintain certain levels of minimum tangible net worth.  The failure to meet those covenants couldprevent us from accessing the working capital line and result in the accelerationof any balances under the working capital line and term loan. On October 20,2003 we announced that we had signed an agreement to merge with Docent, Inc.,Silicon Valley Bank has notified us that they do not view this announcement asa breach of our loan covenants.   If notrenewed the working capital line terminates and any advances made are due onDecember 6, 2004.  At September 30,2003, we had a balance of $41,667 on the term loan facility and $3.5 million onthe working capital line, net of debt discount of $111,000.

 

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The amount available under the workingcapital line of credit as of September 30, 2003 was 65% of our eligibleaccounts receivable.  This percentagemay be adjusted up or down based on a quarterly analysis by the bank and wasrecently adjusted to 75%.  Eligibleaccounts receivable are those accounts receivable that the bank determines inits good faith business judgment to include in the borrowing base.  Certain accounts, such as accounts that areover 90 days past due, unbilled receivables and foreign or government accounts,are not currently eligible.  Although wemay take steps to include foreign and government accounts in our borrowingbase, there is additional cost involved and we have not deemed it necessary todo so to date.  As a result of thislimitation on eligible accounts, the entire $10 million is not currentlyavailable to us under the line of credit and the entire $10 million may notbecome available in the future. Moreover, because the amount available for borrowing under our agreementis based on our eligible accounts receivable, we may from time to time becomeover-advanced under the line of credit if our eligible accounts receivabledecrease, either because they have been collected but not applied against theexisting advances or because they have become ineligible under the terms of theagreement.  In such a case we may berequired to immediately repay a portion of the amount borrowed sufficient tobring the total amount owed to no more than the total availability under theloan facility.

 

Click2learn had a note payable ofapproximately $630,000 that was paid off during the three month period endedSeptember 30, 2003.

 

If we terminate our planned merger withDocent under certain specified conditions we could be required to pay Docent a$2.5 million termination fee.  Such anevent would negatively impact our liquidity. If Docent terminates our planned merger under certain specifiedconditions they could be required to pay Click2learn a $2.5 million terminationfee.  This fee would cover ouranticipated expenses related to the proposed transaction and therefore wouldnot significantly improve our liquidity.

 

Ourlong-term liquidity will be affected by numerous factors, including whether ornot the announced merger with Docent closes as anticipated, demand for ourAspen platform, the level and timing of revenue, the collection of ourreceivables, the availability of our line of credit, the extent to which weraise additional funds from investors, the timing and extent to which we investin new technology, the expenses of sales and marketing and new productdevelopment, the extent to which competitors are successful in developing theirown products and services and increasing their own market share, acquisitionsof businesses or technologies and other factors.  To the extent that our existing capital resources areinsufficient to fund our activities, we may need to raise additionalfunds.  Such additional funding, ifneeded, may not be available on attractive terms or at all.  If adequate funds are not available onacceptable terms, we may be required tomake further expense reductions, which could significantly restrict ouroperations and limit our ability to enhance our products, fund expansion,respond to competitive pressures or take advantage of business opportunities.

 

Ourcontractual commitments at September 30, 2003 are substantially similar tothose at December 31, 2002 disclosed in our annual report on Form 10-K.

 

**FactorsThat May Affect Future Results of Operations**

 

*Our business andresults of operations are likely to be affected by our announced merger withDocent, Inc.*

 

Theannouncement of the proposed transaction with Docent could have an adverseeffect on our revenue in the near-term if customers delay, defer or cancelpurchases pending consummation of the planned transaction due to potentialuncertainty about the direction of the combined company’s product offerings andits support and service of existing products. To the extent that our announcement of the transaction createsuncertainty among customers such that one or more large customers, or asignificant group of small customers, delays purchase decisions pendingconsummation of the planned transaction, our results of operations could benegatively affected.  Decreased revenuecould have a variety of adverse effects, including negative consequences to ourrelationships with, and ongoing obligations to, customers, suppliers, businesspartners, and others with whom we have business relationships.  In addition, our

 

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quarterly operating results and revenue couldbe substantially below the expectations of market analysts, which could cause adecline in our stock price.

 

*Ourquarterly operating results are uncertain and may fluctuate significantly,**which could negatively affect the value of yourinvestment.*

 

Our operating results are difficult topredict accurately and have varied significantly from quarter to quarter andare likely to continue to fluctuate as a result of a variety of factors, manyof which we cannot control. Factors that may adversely affect our quarterlyoperating results include:

 

•                       the size and timing of product orders and thetiming and execution of professional services engagements;

•                       the mix of revenue from products and services;

•                       the mix of products sold;

•                       the ability to meet client project milestones;

•                       the market acceptance of our products andservices;

•                       theability to develop and market new or enhanced products and services in a timelymanner and the market acceptance of these products and services;

•                       the timing of revenue and expense recognition;and

•                       recognition of impairment of existing assets.

 

Our future revenue is difficult to predictand we may not be able to adjust spending in response to revenue shortfalls.Our limited operating history with our current enterprise learning solutionsand the rapidly evolving nature of the enterprise learning market makeprediction of future revenue and expenses difficult. Expense levels are based,in part, on expectations as to future revenue and largely are fixed in theshort term.  If we are unable to predictfuture revenue accurately, we may be unable to adjust spending in a timelymanner to compensate for any unexpected revenue shortfall.

 

*Ourbusiness may not generate the cash needed to finance our**operations, and for that and other reasons we mayneed additional financing in**the future, which we may be unable to obtain.*

 

If our business does not generate the cashneeded to finance our operations, we may need to obtain additional financing ortake steps to restrict our operations in order to conserve existing cash.  In addition, poor financial results orunanticipated expenses could give rise to additional financing requirements. Wemay be unable to obtain financing on terms favorable to us, or at all.  If we need to obtain financing and adequatefunds are not available or are not available on acceptable terms, we may berequired to make further expense reductions, which could significantly restrictour operations and limit our ability to enhance our products, fund expansion,respond to competitive pressures or take advantage of business opportunities.

 

*We may sufferadditional adverse consequences if the proposed transaction with Docent is notcompleted.*

 

Ifthe planned merger with Docent is not completed, we could suffer a number ofconsequences that may adversely affect our business, results of operations andstock price, including the following:

 

•                  wewould not realize the benefits we expect from becoming part of a combinedcompany with Docent, including the potentially enhanced financial andcompetitive position;

•                  activitiesrelating to the merger and related uncertainties may divert our management’sattention from our day-to-day business and cause disruptions among ouremployees and to our relationships with customers and business partners, thusdetracting from our ability to increase revenue and minimize costs and possiblyleading to a loss of revenue and market position that we may not be able toregain if the transaction does not occur;

 

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•                  themarket price of our common stock could decline following an announcement thatthe merger has been abandoned, to the extent that the current market pricereflects a market assumption that the merger will be completed;

•                  wecould be required to pay Docent a $2.5 million termination fee if the mergeragreement is terminated under certain specified conditions;

•                  wewould remain liable for certain costs related to the transaction, such aslegal, accounting, financial advisor and financial printing fees;

•                  wemay not be able to continue our present level of operations and therefore mayhave to scale back our present level of business and consider additionalreductions in force; and

•                  we may not beable to take advantage of alternative business opportunities or effectivelyrespond to competitive pressures.

 

*Salescycles are lengthy, requiring considerable additional investment with noassurance of generating revenue from our efforts.*

 

The period between our initial contact with apotential customer and that customer’s purchase of our products and services islengthy and may extend over several fiscal quarters.  To sell our products and services successfully, we companygenerally must educate our potential customers regarding the use and benefitsof our products and services, which can require significant time, capital andother resources.  The delay or failureto complete sales in a particular quarter could reduce our revenue in thatquarter, as well as subsequent quarters over which revenue for the sale wouldlikely be recognized.  If the salescycle unexpectedly lengthens in general or for one or more large orders, itwould negatively affect the timing of our revenue and our revenue growth wouldbe harmed.

 

Although we must expend and allocateresources prior to completing a sales transaction, we may never generate anyrevenue from these activities.  Inaddition, many of our potential customers are large enterprises that generallytake longer than smaller organizations to make significant business decisions.

 

Moreover, our revenue will be subject to fluctuation asa result of general economic conditions and overall spending in the technologyand enterprise software sectors. A weakening economy could result inorganizations further delaying, canceling, or reducing capital expendituresgenerally and spending on enterprise software applications in particular.  A significant portion of our revenue is derivedfrom the sale of products and services to large companies or governmentagencies, which historically have reduced their expenditures for enterprisesoftware applications during economic downturns.

 

Any failure to meetinvestor expectations for a given quarter as a result of delayed customerdecisions, reduced order sizes or failed sales efforts would likely cause theprice of our common stock to decline.

 

*Wehave a history of losses and may have continued losses in the future.*

 

We incurred a net loss ofapproximately $3.1 million for the nine months ended September 30, 2003.  As of September 30, 2003, our accumulateddeficit was $233.1 million.  Althoughour business generated positive cash flow from operations over the nine-monthperiod ending September 30, 2003, we have not yet achieved profitability andmay not do so. Even if we do achieve profitability, we may be unable to sustainor increase profitability on a quarterly or annual basis.

 

*Wehave a limited operating history with the Aspen suite, which makes it**difficult to predict our future performance.*

 

The primaryfocus of our business is and throughout 2003 will continue to be the Aspensuite.  We released the first version ofthe Aspen suite in September 2001 and released the first major upgrade inSeptember 2002. Accordingly, we have a limited operating history on which toevaluate our current business and future prospects. Our limited operatinghistory with the Aspen suite makes it difficult to

 

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predict our future performance and may not provide investors with ameaningful basis for evaluating an investment in our common stock.

 

*Theenterprise learning software market may not grow to a sufficient size or at asufficient rate to sustain our**business.*

 

The enterprise learning software market maynot grow to a sufficient size or at a sufficient rate for our business tosucceed. Corporate training and education historically have been conductedprimarily through classroom instruction. Although technology-based trainingapplications have been available for many years, they currently account foronly a small portion of the overall corporate learning market. Accordingly, oursuccess will depend on the extent to which companies implement enterprise learningsoftware solutions for the design, development, delivery and management oftheir corporate learning needs.

 

Many companies that have already investedsubstantial resources in traditional training methods may be reluctant to adopta new strategy that may limit or compete with their existing investments. Evenif companies implement enterprise learning software solutions, they may stillchoose to develop such solutions internally. If the use of enterprise learningsoftware does not become widespread or if companies choose to develop suchsoftware internally rather than acquiring it from third parties, then ourenterprise learning software may not be commercially successful.

 

*Weface risks encountered in rapidly evolving markets and may be unsuccessful in**addressing these risks.*

 

We face risks frequently encountered inrapidly evolving markets. Specific risks we face relate to the demand for andmarket acceptance of our enterprise learning solutions. We may fail toadequately address these risks, and therefore our business may suffer. Toaddress these risks, we must:

 

•                       effectively market our enterprise learningsoftware to new and existing customers;

•                       continue to enhance the technology upon which ourenterprise learning software is based;

•                       successfully implement our enterprise learningsoftware for our customers and generate continuing revenue from thosecustomers; and

•                       address and establish new technologies andtechnology standards.

 

*Weface intense competition from other enterprise learning software providers**and may be unable to compete successfully.*

 

The enterprise learning software market ishighly fragmented and competitive, with no single firm accounting for adominant market share. Our competitors vary in size, scope and the breadth ofproducts and services offered. We face competition from:

 

•                       other developers of enterprise learning systems;

•                       providers of other enterprise software solutions;

•                       large professional consulting firms and in-houseIT departments; and

•                       developers of web authoring tools.

 

There are relatively low barriers to entry inthe enterprise learning market and new competitors may enter this market in thefuture. Increased competition may result in price reductions, reduced grossmargins and loss of market share. We may not be able to contend effectivelywith such increased competition.  Inparticular, vendors of other enterprise software applications such asenterprise resource planning, human resource management or customerrelationship management have begun to offer learning delivery and managementfunctionality to extend their current product lines within their existingcustomer base.  Although these offeringsmay not offer the same functionality as our Aspen suite, bundling theseofferings with the remainder of their solutions could diminish our ability tosell our products and services to

 

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their customers and announcements by thesecompanies of future products could delay purchasing decisions by theircustomers and our prospects, either of which could adversely affect ourbusiness.

 

Certain of our existing and potentialcompetitors have longer operating histories and significantly greaterfinancial, technical, marketing and other resources and therefore may be ableto respond more quickly to new or changing opportunities, technologies,standards and customer requirements or to compete more aggressively on pricing.Price competition would likely result in reduced gross margins and may preventthe Aspen suite from yielding results sufficient for our business to succeed.

 

Strategic relationships are important inexpanding the distribution reach of companies in the enterprise learningmarket. If our competitors were to establish strategic relationships to resellor distribute their products through their strategic partners, our ability tomarket and sell products and services successfully may be substantiallydiminished. In addition, the existence or announcement of strategicrelationships involving our competitors could adversely affect our ability toattract and retain customers.

 

*Internationaloperations may impose substantial burdens on our resources, divert**management’s attention or otherwise harm ourbusiness.*

 

We rely on independent partners in foreigncountries to help conduct our international operations and sales and marketingefforts. Our success in international markets consequently will depend to alarge degree on the success of these independent partners, over which we havelittle control. If they are unwilling or unable to dedicate sufficientresources to our relationships, our international operations will suffer.

 

We rely on our operations in Hyderabad, Indiato enable us to complete customer implementation projects and new releases ofthe Aspen suite on time and within our established budgets.  Should our operations in Hyderabad bedisrupted for any significant period of time, it could prevent us fromcompleting customer implementations or new releases of the Aspen suite in atimely manner, which could cause our business to suffer.

 

Our efforts in Hyderabad and elsewhere abroadare subject to a number of risks inherent in international operations,including:

 

•                       diversion of management attention;

•                       difficulties and costs of staffing and managingforeign offices;

•                       different learning styles and cultures;

•                       numerous and potentially conflicting regulatoryrequirements;

•                       export controls, import tariffs and otherbarriers to trade;

•                       changes in laws or governmental policies;

•                       reduced protection of intellectual propertyrights;

•                       regional political and economic instability; and

•                       fluctuations in currency exchange rates.

 

*Ourdebt covenants may significantly restrict our operations.*

 

We are subject to numerous covenants in ouragreement with Silicon Valley Bank that impose financial and operatingrestrictions on our business if we wish to maintain availability of the creditfacility. These restrictions may affect our ability to operate our business,may limit our ability to take advantage of potential business opportunities asthey arise, and may adversely affect the conduct of our current business. Thesecovenants place restrictions on our ability to, among other things:

 

•                       incur debt with parties other than Silicon ValleyBank;

•                       pay dividends, redeem or repurchase our stock ormake other distributions;

•                       make acquisitions or investments;

 

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•                       engage in new or different businesses;

•                       change our capital structure;

•                       use assets as security in other transactions;

•                       enter into transactions with affiliates oroutside the ordinary course of business;

•                       merge or consolidate with others or acquireassets outside the ordinary course of business;

•                       dispose of assets or use asset sale proceeds;

•                       create liens on our assets; and

•                       extend or guaranty credit.

 

In addition, the terms of our indebtednessrequire that we meet certain financial covenants related to maximum net lossesand minimum tangible net worth. The covenants governing our existingindebtedness restrict our operations and those of our subsidiaries, and theselimitations could impair our ability to meet such financial covenants. Inaddition, our ability to meet these financial covenants and to comply withother provisions governing our indebtedness may be affected by changes ineconomic or business conditions or other events beyond our control. Moreover,failure to comply with our debt-related obligations could result in an event ofdefault that, if not cured or waived, could result in an acceleration of ourindebtedness.  We are currently incompliance with these covenants, but we cannot assure you that we will notviolate these covenants in the future. In the past, we have on occasion violated certain of the covenants underour loan agreements with Silicon Valley Bank and the bank has waived thoseviolations without cost to us.  However,we cannot assure you that the bank will waive any future violations at no costto us, or at all.

 

Moreover, because the amount available forborrowing under our agreement is based on our eligible accounts receivable, wemay from time to time become over-advanced under the line of credit if oureligible accounts receivable decrease, either because they have been collectedbut not applied against the existing obligations or because they have becomeineligible under the terms of the agreement. In such a case we may be required to immediately repay a portion of theamount borrowed sufficient to bring the total amount owed to no more than thetotal availability under the loan facility.

 

*Theloss of the services of our senior executives and key personnel would**likely cause our business to suffer.*

 

Our success depends to a significant degreeon the performance of the senior management team and other key employees. Theloss of any of these individuals could harm our business. We do not haveemployment agreements with several of our executives or with any other keyemployees, and we do not maintain key person life insurance for any officers orkey employees.

 

Our success also depends on our ability toattract, integrate, motivate and retain highly skilled technical, sales andmarketing and professional services personnel. Competition for qualifiedpersonnel in the software industry is intense. To the extent we are unable toattract and retain skilled personnel our business will suffer.

 

*OurAspen suite is a new product and may contain defects or otherwise**perform improperly.*

 

Our Aspen suite was initially released inSeptember 2001, and the first major version upgrade was released in September2002.  We anticipate continuing to addnew features, functionality and components. Complex enterprise softwareproducts frequently contain errors or failures, especially when firstintroduced or when new versions are released. Because the Aspen products arecomplex software packages with new features and functionality being added andnew versions being released on a regular basis, there is a greater likelihoodthat they may contain such errors. In addition, since the Aspen suite istargeted at enterprise customers with large numbers of users, customers andpotential customers may have a greater sensitivity to product defects orproduct integration than the market for software products generally. To date wehave experienced errors in the Aspen platform, in particular when new versionsor functionality is first released, although such errors have not had amaterial impact on our business and generally have been corrected

 

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shortly after discovery.  Although we have not experienced this todate, serious product errors could result in loss of revenue or delay in marketacceptance, diversion of development resources, damage to our reputation, orincreased service and warranty costs.

 

*Wemay not be able to adapt to rapidly changing technology and evolving**industry standards.*

 

The enterprise learning software market ischaracterized by rapidly changing technologies, frequent new product andservice introductions, short development cycles and evolving industrystandards. The introduction of new products and services embodying newtechnologies and the emergence of new industry standards may render ourproducts and services obsolete. Our success depends on our ability to adapt toa rapidly changing landscape and to offer new products and services to addressour customers’ changing demands. We may experience difficulties that delay orprevent the successful design, development, introduction or marketing of ourproducts and services. To the extent we in fact experience such delays, we mayexperience difficulty in attracting new customers and may lose existingcustomers.

 

*Ifwe are unable to build the Click2learn and Aspen brands, we may be unable to**grow our business.*

 

We believe that establishing and maintainingthe Click2learn and Aspen brands will be critical to the success of ourenterprise learning strategy and that the importance of brand recognition willincrease as the market for enterprise learning software products grows. If ourbrand building strategy is unsuccessful, our business could be materiallyharmed.

 

*Weface the risk of liability for failures to meet unique customer**requirements, and the risk of cost overruns onfixed-price projects.*

 

The failure or inability to meet a customer’sunique expectations or requirements in the performance of services could impairour reputation or result in a claim for damages, regardless of ourresponsibility for the failure. Although generally we attempt to limitcontractually our liability for damages arising from product defects and othermistakes in rendering professional services, these contractual protections arenot always obtained and may not be enforced or otherwise may not protect usfrom liability. Our insurance may not be sufficient to cover these claims.  In addition, most of our professionalservices projects are performed on a fixed-price basis rather than on a timeand materials basis. If we do not complete fixed-price engagements withinbudget, on time and to clients’ satisfaction, we bear the risk of costoverruns.

 

*Securityand privacy breaches could subject us to litigation and liability.*

 

We host certain of our customers’ enterpriselearning software implementations at our data center and provide access to thatsoftware using the Internet. The Internet is a public network and data is sentover this network from many sources. Although we take reasonable steps inaccordance with current industry practices to ensure the security of ourhosting systems and customer data, computer viruses could be introduced intoour systems or those of our customers, which could disrupt the operation of ourhosting systems or make them inaccessible to users. We depend on Internetservice providers and telecommunications companies and the efficient operationof their computer networks and other computer equipment to enable customers toaccess and use hosted software implementations. Each of these has experiencedsignificant outages in the past and could experience outages, delays and otherdifficulties due to system failures unrelated to our systems, which could causeour customers to believe we were at fault and withhold payments due to us.

 

We could become subject to litigation andliability if third parties penetrate security for our hosting systems orotherwise misappropriate our users’ confidential information or if customersare unable to access and use hosted software implementations. Advances incomputer capabilities, new discoveries in the field of cryptography or othertechnological events or developments could result in compromises or breaches ofour security systems. Anyone who circumvents our security measures couldmisappropriate

 

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proprietary information or causeinterruptions in our services or operations. We may be required to expendsignificant capital and other resources to protect against the threat ofsecurity breaches or service interruptions or to alleviate problems caused bybreaches or service interruptions.

 

*Acquisitionsor investments may drain capital and equity resources, divert**management’s attention or otherwise harm ourbusiness.*

 

In the future we may acquire or makeinvestments in other businesses, products or technologies. Such acquisitions orinvestments may require that we pay significant cash, issue stock or incursubstantial debt. In addition, such acquisitions or investments may requiresignificant managerial attention, which may be diverted from our otheroperations. These capital, equity and managerial commitments may impair theoperation of our business. Furthermore, acquired businesses may not beeffectively integrated, may be unable to maintain key pre-acquisition businessrelationships, may contribute to increased fixed costs and may expose us tounanticipated liabilities.

 

*Ourintellectual property may become subject to legal challenges, unauthorized**use or infringement, any of which could diminish thevalue of our products and**services.*

 

Our success depends in large part on ourproprietary technology. We rely on a combination of copyrights, trademarks,trade secret laws, restrictions on disclosure and other methods to protect ourproprietary technology.  We do not havepatents for any of the technology underlying our Aspen platform. If we fail tosuccessfully enforce our intellectual property rights, the value of these rights,and consequently the value of our products and services to our customers, coulddiminish substantially. It may be possible for third parties to copy orotherwise obtain and use our intellectual property or trade secrets without ourauthorization, and it may be possible for third parties to independentlydevelop substantially equivalent intellectual property.

 

Litigation may be necessary in the future toenforce our intellectual property rights, to protect trade secrets or todetermine the validity and scope of the proprietary rights of others. From timeto time we have received, and may in the future receive, notice of claims ofinfringement of other parties’ proprietary rights. Such claims could result incostly litigation and could divert management and technical resources. Theycould also delay product shipment or require us to develop non-infringingtechnology or enter into royalty or licensing agreements, which agreements maynot be available on reasonable terms, or at all.

 

*Ourproducts include third-party technology, the loss of which could materially**harm our business.*

 

We use some licensed third-party technologycomponents in our products. Future licenses to this technology may not beavailable to us on commercially reasonable terms, or at all. The loss of orinability to obtain or maintain any of these technology licenses could resultin delays in the introduction of new products or could force us to discontinueoffering portions of our enterprise learning solutions until equivalenttechnology, if available, is identified, licensed and integrated. Furthermore,we may become subject to legal claims related to licensed technology based onproduct liability, infringement of intellectual property or other legaltheories.

 

*Ourstock price has been and may continue to be volatile.*

 

The trading price of our common stock has been and is likely tocontinue to be highly volatile.  Forexample, during the 52-week period ended September 30, 2003, the price of ourcommon stock ranged from $0.52 to $2.41 per share.  Our stock price is subject to continued fluctuations in responseto a number of factors, including:

 

•                       actualor anticipated variations in quarterly operating results;

•                       changesin financial estimates or recommendations by securities analysts;

 

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•                       conditionsor trends in the learning and enterprise software markets;

•                       announcementsby us or our competitors of significant customer wins, technologicalinnovations, new products or services;

•                       announcementsby us or our competitors of significant acquisitions, strategic partnerships,joint ventures or capital commitments;

•                       additionsor departures of key personnel;

•                       salesof our common stock; and

•                       generalmarket conditions.

 

The stock market in general, and the market for enterprise software andtechnology companies in particular, recently has experienced extreme price andvolume fluctuations that have been unrelated or disproportionate to theoperating performance of many of the affected companies.  These broad market and industry factors maydepress our stock price, regardless of our operating performance.

 

In the past, companies that have experienced volatility in the marketprice of their stock have been subject to securities class action litigation.  We may be the targets of this type oflitigation in the future.  Securitieslitigation against us could result in substantial costs and divert ourmanagement’s attention, which could seriously harm our business.

 

**Item 3****. Quantitative and Qualitative Disclosures about Market Risk**

 

*Market Rate Risk.*We are exposed to market risk related to changesin interest rates and foreign currency exchange rates. We do not use derivativefinancial instruments for speculative or trading purposes.

 

*Interest Rate Risk.*We hold our assets primarily in cash and cashequivalents, such as short-term marketable debt securities, money market fundsand other cash equivalents. We minimize risk by investing in financialinstruments with maturity of three months or less. As a result, if marketinterest rates were to increase immediately and uniformly by 10% from levels atDecember 31, 2002, the fair value of cash and cash equivalents would not changeby a material amount.

 

*Foreign Currency Exchange Risk.*We have foreign currency risk as a result offoreign subsidiary activities. For the three and nine months ended September30, 2003, international revenue from foreign subsidiaries accounted forapproximately 11% and 9%, respectively, of total revenue. All foreignsubsidiaries use the local currency as their functional currency.

 

Our exposure to foreign exchange ratefluctuations arises in part from intercompany accounts in which costs incurredin the United States are charged to the foreign subsidiaries. Theseintercompany accounts are typically denominated in the functional currency ofthe foreign subsidiary in order to centralize foreign exchange risk with theparent company in the United States. We are also exposed to foreign exchangerate fluctuations as the financial results of foreign subsidiaries aretranslated in U.S. dollars in consolidation. As exchange rates vary, theseresults, when translated, may vary from expectations and adversely impactoverall expected profitability. The effect of foreign exchange ratefluctuations for the nine months ended September 30, 2003 was not material. Dueto the substantial volatility of currency exchange rates, among other factors,we cannot predict the effect of exchange rate fluctuations on our futureoperating results.

 

**Item 4**.  Controls and Procedures

** **

Click2learn maintains a set of disclosurecontrols and procedures designed to ensure that information required to bedisclosed in filings made pursuant to the Securities Exchange Act of 1934 (the“Exchange Act”) is recorded, processed, summarized and reported within the timeperiods specified in the Securities and Exchange Commission’s rules and forms.Our principal executive and financial officers have

 

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evaluated ourdisclosure controls and procedures as of the end of the period covered by thisreport and have determined that such disclosure controls and procedures areeffective.

 

No changes were made to our internal control over financial reportingin connection with this evaluation that has materially affected, or isreasonably like to materially affect, our internal control over financialreporting.

 

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**PARTII****—OTHERINFORMATION**

### ** **

**Item1.  LegalProceedings**

 

Not applicable.

 

**Item2.**           **Changes In Securities and Use ofProceeds**

 

Not applicable.

 

**Item 3. Defaults Upon Senior Securities**

 

Not applicable.

 

**Item4.**           **Submission of Matters to a Vote ofSecurities Holders**

 

Not applicable.

 

**Item 5****.**           **OtherInformation**

 

On October 20,2003, we announced the execution of an Agreement and Plan of Reorganization,dated as of October 20, 2003 (the “Merger Agreement”), by and among us,Docent, Hockey Merger Corporation, a Delaware corporation (“Newco”), CanuckAcquisition Corporation, a Delaware corporation and a wholly-owned subsidiaryof Newco (“Click2learn Merger Sub”) and Devil Acquisition Corporation, aDelaware corporation and a wholly-owned subsidiary of Newco (“Docent MergerSub”).  In the transaction, Click2learn Merger Sub will merge with and intous and each issued and outstanding share of our common stock will be exchangedfor 0.4144 shares of Newco common stock (the “Click2learn Exchange Ratio”),Docent Merger Sub will merge with and into Docent and each issued andoutstanding share of Docent common stock will be exchanged for 0.9525 shares ofNewco common stock (the “Docent Exchange Ratio”).  In addition, (i) eachoutstanding option and warrant to purchase shares of our common stock will beassumed by Newco and will represent the right to purchase a number of shares ofNewco common stock based on the Click2learn Exchange Ratio, and the exerciseprice per share will be adjusted accordingly, and (ii) each outstanding optionand warrant to purchase Docent common stock will be assumed by Newco and will representthe right to purchase a number of shares of Newco common stock based on theDocent Exchange Ratio, and the exercise price per share will be adjustedaccordingly.  The separate corporate existences of Click2learn Merger Suband Docent Merger Sub will thereupon cease and Docent and us will each continueas wholly owned subsidiaries of Newco.

 

The consummation ofthe merger is subject to the approval of our stockholders and the stockholdersof Docent and other customary closing conditions. The merger is intended to bea tax-free reorganization under Section 368 of the Internal Revenue Codeof 1986, as amended (the “Code”) and/or qualify as a tax-free exchange underSection 351 of the Code, and is expected to be treated as a purchase forfinancial accounting purposes, in accordance with generally accepted accountingprinciples generally accepted in the United States of America.

 

The foregoingdescription of the Merger Agreement does not purport to be complete and isqualified in its entirety by the terms and conditions of the MergerAgreement.  Copies of the Merger Agreement and other documents related tothe transaction are attached as exhibits to the Current Report of Form 8-K wefiled with the Securities and Exchange Commission on October 20, 2003.

 

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**Item 6****.  Exhibits and Reports on Form 8-K**

 

(a)                                  Exhibits.

 

31.1                           Certifications of Chief Executive Officerpursuant to Section 302 of the Sarbanes-Oxley Act of 2002

 

31.2                           Certification of Chief Financial Officer pursuantto Section 302 of the Sarbanes-Oxley Act of 2002

 

32.1                           Certification of Chief Executive Officer andChief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuantto Section 906 of the Sarbanes-Oxley Act of 2002

 

 (b)                             Reports on Form 8-K.

 

A report on Form8-K dated July 25, 2003 was filed announcing results of operations for the sixmonths ended June 30, 2003.  Nofinancial statements were filed with such report.

 

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**SIGNATURES**

 

Pursuant to the requirements of the Securities Exchange Act of 1934,the registrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 
|              |   | **CLICK2LEARN, INC.**                                                                             |
|-------------------|--------|---------------------------------------------------------------------------------------------------|
|              |   |                                                                                              |
|              |   |                                                                                              |
| November 12, 2003 |   | /s/John D. Atherly                                                                                |
| Date              |   | John D. Atherly  Chief Financial Officer  (Duly Authorized Officer and Chief Accounting  Officer) |

 

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**Exhibit List**

 

31.1                           Certifications of Chief Executive Officerpursuant to Section 302 of the Sarbanes-Oxley Act of 2002

 

31.2                           Certifications of Chief Financial Officerpursuant to Section 302 of the Sarbanes-Oxley Act of 2002

 

32.1                           Certification of Chief Executive Officer andChief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuantto Section 906 of the Sarbanes-Oxley Act of 2002

 

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